Secure Income REIT — Easy to predict, very hard to emulate

SIR’s strategy of investing in properties producing highly predictable and long-term income streams has produced FY16 results in line with expectations apart from a larger revaluation gain than the market had forecast, as a result of yield tightening and increases in rental income. We summarise the results below before discussing the main points in more detail.

The results show the predictability of SIR’s earnings, based on stable rent growth, strong tenant covenants and fixed debt. These underpin a dependable dividend stream and contribute to valuation increases if yields remain steady. As has been seen in 2016, the demand for steady and secure income can put pressure on yields, driving asset values up even more. While uncertainties related to cyclical factors and exceptional circumstances such as the UK’s relationship with the EU persist, SIR is likely to see capital values increase further.

Rental income was lower in 2016 than 2015 (£80.4m vs £86.5m) as a result of the Madame Tussauds sale in mid-2015; the rent-smoothing effect was also slightly lower, being one year further into the leases. This is explained in more detail in our initiation note, but briefly, IFRS requires that where rents are known throughout a lease, the landlord should report the average rent every year as revenue. The delta between average rent and actual rent is accrued on the balance sheet as a receivable in the first half of a lease, and unwinds in the second half. The annual change is deducted from the revaluation gain (Exhibit 1). In this way revenue is accrued evenly and value is not exaggerated.

Administrative expenses were higher in 2016 than 2015, mainly due to the incentive fee earned by Prestbury and the costs of the placing in March 2016. The incentive fee is calculated as 20% of returns in excess of a hurdle of 10% total NAV return (NAV increases + dividends paid), provided that a high water mark is surpassed. The incentive fee came to £9.4m in 2016 (to be paid in shares) and the 31 December 2016 EPRA NAV is now the high watermark. The reported cost of £10.5m includes £1.1m of irrecoverable VAT paid by SIR in cash. EPRA NAV before distributions will have to be 356p at the end of 2017 for the manager to earn an incentive fee for the current year. Without the incentive fee, the EPRA cost ratio would have been 12%, one of the lowest in the sector; including the incentive fee, the ratio was 23.2%, nearer the sector average.

After adjusting for costs incurred to reduce debt in 2015 and profits from sales of investment property, EPRA earnings were up 24%. On a per share basis (and adjusting for 3.3m shares paid to the adviser in consideration of the incentive fee) fully diluted earnings came to 11.1p.

Changes in the value of the investment property portfolio are illustrated in Exhibit 3. Revaluation totalled £85.0m, or £72.2m adjusting for rent smoothing. The head lease liability is also included as a liability in the balance sheet, meaning that it does not affect NAV. The foreign exchange effect reflects sterling weakness against the euro, lifting the value of the German assets further.

The absolute increase in NAV was largely due to the £140m gross capital increase (£137.5m net) for the acquisition of the Travelodge hotel portfolio (acquired in October 2016 for £196m). This was priced at post-acquisition NAV and therefore neutral on a per share basis.

The main drivers of the NAV per share increase were the revaluation gain of £85.0m and some retained earnings (in future, retained earnings will likely be paid out as dividends). EPRA NAV adjusts for the dilution from the incentive fee shares (-4.6p per share) and adds back the deferred tax on the German property revaluations (+3.7p per share).

Management has indicated that it does not intend to refinance debt in the foreseeable future, but would use any future acquisitions as an opportunity to reduce LTV by acquiring new assets at lower gearing. We also note the structural tendency for LTV to fall as rising rents push up capital values. We use the RPI swap curve as of 3 March 2017 to predict RPI-linked rental increases and, knowing the fixed rate uplifts, if we assume that valuation yields remain the same as at 31 December 2016, LTV is set to fall below 50% in mid-2019. With its current scale, SIR should have broad access to debt markets if and when it finances a new acquisition.

There is a possibility of further growth from a rent review on the hospitals let to Ramsay which is due to take place in May 2017; normally rents on these assets rise 2.75% pa, but in 2017 they may rise to the higher of a 2.75% increase or 57.525% of site EBITDARH (earnings before interest, tax, depreciation, amortisation, rent and head office costs). Every five years thereafter they may be set by an open market review at SIR’s option. The outcome of this review will be known in H217.

The changes to our EPS forecasts are mainly from the increased number of shares due to the incentive fee; this reduces EPS and therefore DPS. The fee was earned because of the 16.5% NAV and dividend return achieved in 2016, which is also reflected in our forecasts. Despite the fee impact, the NAV gain means that we have lifted our EPRA NAV per share forecasts by c 8%. Our net rental income estimates are little affected by the results, but we have updated our RPI and FX assumptions to reflect the current swap curve and exchange rate.

SIR is likely to be shielded from much of the uncertainty associated with the UK’s medium-term political and economic outlook, and also from some of the possible volatility in property returns, both capital and rental. The stability comes from the length of its leases, the nature of the rent reviews and the quality of its tenant covenants. The WAULT is over 23 years, 58% of rental income is subject to fixed uplifts averaging 2.8% annually and the remainder is on upwards-only, uncapped RPI-linked uplifts (with potential upside from five-yearly variations on the Ramsay portfolio). Its tenants are all large, financially sound leaders in their respective markets and SIR’s rents are guaranteed by the parent companies (except in Travelodge’s case where here is no parent, but the lease is to the main trading entity). As a result, although the portfolio is relatively concentrated in terms of sectors and tenants, the businesses which pay the rent effectively diversify it because their revenues come from a wider range of activities and countries (Exhibits 6 and 7). This reduces SIR’s exposure to UK-related risks such as the increasing national living wage, business rate changes and departure from the EU. Ramsay and Merlin both reported strong results for FY16 (which may bode well for the May 2017 rent reviews) and the most recent performance indications from Orpea and Travelodge are also encouraging.

As previously noted, rents and financing and administrative costs are predictable. Assuming constant valuation yields, so is asset growth. Using the same assumptions as mentioned in the previous section, management forecasts a compound annual total NAV return of c 11% out to 2021, which our estimates suggest is slightly conservative (we have different sources for the swap curve and FX assumptions). SIR’s near-term sensitivities are likely to be to the upside: the Ramsay rent reviews may increase rents more than we have assumed and yields may contract further if current market conditions persist.

As evidenced by the yield movements on the portfolio held throughout 2016, long-term stable sources of income are increasingly sought-after, and the sharp decline in the net initial yield on Heide Park in Germany in particular may reflect moves by institutions to acquire similar leases. Management believes that it would not be possible to assemble a portfolio such as SIR’s on similar yields today, a problem which any new entrants to the long-lease sub-sector will have to face.

While this means that continued expansion is not easy for SIR either, the Travelodge deal shows that the Prestbury team is able to find and execute deals which fit its investment criteria, and have several advantages apart from the team’s expertise and networks, including the exemption from capital gains tax enjoyed by REITs, which institutional investors do not have. SIR has an advantage of scale compared with some other long-lease specialists and is not limited by sector specialism (several of the peer group concentrate on healthcare). The managers have simple acquisition criteria:

Management will exercise discipline in selecting new assets and is well aligned with other shareholders because Prestbury and its employees hold c 15% of the shares in aggregate. Ground rent sale and lease-back deals are currently popular among private equity sellers, but do not suit SIR’s criteria, as they are less attractive than full leases in the long term. We do not assume any further acquisitions in our estimates, but note that management has demonstrated the ability to source and execute materially NAV- and earnings-accretive deals.

SIR’s portfolio of very long leases and high quality tenant covenants generate a secure and predictable income stream, supporting an attractive and growing dividend with the likelihood of NAV growth. SIR currently trades at a premium of c 7% to EPRA NAV, broadly in line with the peer group of long-lease specialists when compared on an earnings yield basis, as in the chart below, but also has the lowest premium in absolute terms, which may give shareholders added protection.

We would note that given the large proportion of SIR’s rents which are on fixed uplifts, that NAV growth, given flat valuation yields, is nearly certain. Exhibit 10 implies that this additional return may not yet be recognised by the market.

SIR’s secure, long-term income streams insulate it to some extent from short-term uncertainties. Tenant risk is low, given the scale and financial health of its occupiers and the nature of the leases provides some protection against inflation. The main sensitivities are therefore to valuation yields and the possibility of further portfolio growth.

As a result of increased competition in a low interest rate environment, assets like SIR’s are no longer available at the yields on which it acquired them and are very hard to find at their current valuation yields. We would argue that the valuations offer some protection against yield expansion should the cycle progress, with the likelihood of further yield compression in the short term.

However, while new assets which would complement the existing portfolio are scarce, Prestbury has demonstrated the ability to find them. Any new assets would need to comply with its acquisition criteria, complement the existing portfolio and thus be NAV and earnings accretive.